Sami Al-SuwailemIRTI, IDB

Thul-Qida 1430H –November 2009

Introduction

to Islamic Finance

Pillars of Islamic FinanceNon-profit Domain For-profit Domain

For-profit domainNon-profit domain A balanced approach

Like a bird, an economy needs the two sectors to fly

Brotherhood replaces both individualism and communism

Brothers are similar enough to promote sympathy and cooperation

But they are different enough to allow for specialization and trade

Brotherhood encompasses both domains

ZakatNafaqatInheritance lawSharing in times of necessity,

starvation, or hardship

Obligatory donationApplies to idle money (not used for

one year)Measure against hoarding Hoarding and the current financial

crisis?

Obligatory spending for designated relatives

Parents, family, close relativesSubject to need

CoordinationCivil standards“Tragedy of the commons”“The whole is greater than the sum”

Safety netLess moral hazard than government net

Preservation of wealth

Happiness cannot be achieved by one domain

Balance allows both to flourish and thrive

Prohibition of israfProhibition of usury or ribaProhibition of gharar or wagering

Over-spending or over-utilization of resources

In consumption:extravagant spendingConspicuous consumption and status

gamesIn investment:

Greed—“Irrational exuberance”Bubbles => crashes

Wealth preservation is an essential objective of Shari’ah

Israf violates preservation of wealthResults: pollution, global warming,

depletion of resourcesEssence of economics is to avoid israf

Riba or usury: any stipulated addition over a loan

Includes both simple and compound interest

Prohibited by all divine religions as well as Buddhism

Two-thirds of world population subscribe to this belief

Debt grows faster than wealthDebt cannot be paid except with new

debtDebt burden destroys the economy

2,391,102,204,613,620,000,000,000,000,000,000,000,000,000

60,806,303,788,323,700,000,000,000,000,000

1,546,318,920,731,950,000,000

1000

1500

2000

1 pence borrowed at 4%

in 1 AD

In 1750 debt equals weight of the globe of

goldIn 1990 it equals 8190 globes!

Average growth annual rate:Debt: 39%,GDP: 21%,M2: 19%

Debt-GDP ratio: 1.3 to 2.2Debt-M2 ratio: 2.2 to 4.2

Debt

Wealth

Inverted pyramid is not sustainableCrashes needed to “clean up” the

systemThen debts start to accumulate

again faster than wealthRecurrent crashesVery costly to maintain the system

Theory: Intertemporal Budget Constraint:The present value of debt go to zeroPrevents Ponzi financing

Reality: E.U. requirements:Deficit < 3% of GDPDebt < 60% of GDP

Problem: Need to govern debt from the ground-up

Debt creation is integrated with wealth creation

For-profit debt must be contractually embedded in real transactions

Islamic modes of finance:Deferred sale; salam; leasing;

Sale of a good for a deferred pricePrice includes markupTime value is paired with real valueMurabaha: Financing deferred sale

Opposite of deferred salePrice is spot; good is deferredTime-value is reflected in lower price

Similarity negates gain from tradeVariety allows mutual benefitDiversity is essential for prosperityStronger similarity imposes stronger

restrictions of exchangeRiba: imbalanced exchange of

similars

SimilarityLow High

Trade Loan

High valueLow restrictions

Low valueHigh restrictions

Wealth

Debt

Creditor must forbear if debtor is in difficulty

Why forbearance is important for stability?Foreclosure causes prices to fallWhich leads to additional defaultsWhich leads to more foreclosuresWhich makes prices go even lowerAnd so forth

Unregulated credit expansion

Regulated credit expansion

Forbearance enacted

No forbearance

Universal principlesSound economic reasoning Balanced approach